372 Part Four Financing Decisions and Market Efficiency
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The money to make the loan comes mainly from the sale of insurance policies. Say you buy a
fire insurance policy on your home. You pay cash to the insurance company and get a finan-
cial asset (the policy) in exchange. You receive no interest payments on this financial asset,
but if a fire does strike, the company is obliged to cover the damages up to the policy limit.
This is the return on your investment. (Of course, a fire is a sad and dangerous event that you
hope to avoid. But if a fire does occur, you are better off getting a return on your investment
in insurance than not having insurance at all.)
The company will issue not just one policy but thousands. Normally the incidence of
fires “averages out,” leaving the company with a predictable obligation to its policyholders
as a group. Of course the insurance company must charge enough for its policies to cover
selling and administrative costs, pay policyholders’ claims, and generate a profit for its
stockholders.14-5 The Role of Financial Markets and Intermediaries
Financial markets and intermediaries provide financing for business. They channel savings to
real investment. That much should be loud and clear. But other functions may not be quite so
obvious. Financial intermediaries contribute in many ways to our individual well-being and
the smooth functioning of the economy. Here are some examples.The Payment Mechanism
Think how inconvenient life would be if all payments had to be made in cash. Fortunately,
checking accounts, credit cards, and electronic transfers allow individuals and firms to send
and receive payments quickly and safely over long distances. Banks are the obvious provid-
ers of payments services, but they are not alone. For example, if you buy shares in a money-
market mutual fund, your money is pooled with that of other investors and is used to buy safe,
short-term securities. You can then write checks on this mutual fund investment, just as if you
had a bank deposit.Borrowing and Lending
Financial institutions do not lend only to companies. They also channel savings toward those
who can best use them. Thus, if Ms. Jones has more money than she needs now and wishes
to save for a rainy day, she can put the money in a bank savings deposit. If Mr. Smith wants
to buy a car now and pay for it later, he can borrow money from the bank. In other words,
banks provide Jones and Smith with a time machine that allows them to transport their wealth
backward and forward over time. Both are happier than if they were forced to spend cash as
it arrived.
As we saw in Chapter 1, when individuals have access to borrowing and lending, compa-
nies do not have to worry that shareholders may have different time preferences. Companies
can simply focus on maximizing firm value and investors can choose separately when they
want to spend their wealth.
Notice that banks promise their checking account customers instant access to their money
and at the same time make long-term loans to companies and individuals. This mismatch
between the liquidity of the bank’s liabilities (the deposits) and most of its assets (the loans) is
possible only because the number of depositors is sufficiently large that the bank can be fairly
sure that they will not all want to withdraw their money simultaneously.
In principle, you don’t need financial institutions to provide borrowing and lending. Individ-
uals with cash surpluses, for example, could take out newspaper advertisements to find those
with cash shortages. But it can be cheaper and more convenient to use a financial intermediary,